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Beware the End-of-Year 401(k) Match

AOL’s chief executive, Tim Armstrong, drew plenty of attention earlier this month when he seemed to attribute a change in the company’s 401(k) plan in part to a couple of employees whose infants required expensive care. But what was mostly lost in the discussion was just how much it would cost employees if every employer tried to do what AOL did.

The answer? Close to $50,000 in today’s dollars by the time they retired, according to calculations that the 401(k) and mutual fund giant Vanguard made this week. That buys a lot of trips to see the grandchildren — or scores of nights in a nursing home.

Mr. Armstrong ultimately reversed the change after the uproar over the singling out of particular employees. Still, everyone who saves in a 401(k) or similar plan needs to take a close look at what AOL was trying to do, so they can recognize it and protest if their employer tries to do something like it. While there are plenty of federal regulations governing the basic administration and safeguarding of employer-provided retirement accounts, companies have a lot of leeway to alter their own plans in ways that can cost employees plenty. AOL’s attempt is an unpleasant reminder that employers can and will make changes to employee benefits programs for any reason at all.

Most companies that match your contributions to a workplace retirement account deposit that match each time you get a paycheck. AOL wanted to wait until the end of each year and deposit any match all at once. People who left the company during the year, by choice or by layoff, would have gotten no match at all, not even a prorated one.

Not many companies have adopted these so-called last-day rules so far. As of the end of 2011, just 7 percent of clients at the benefits consulting firm Mercer deposited their 401(k) matches annually. Aon Hewitt’s 2013 study put the number at 8 percent. The latest Plan Sponsor Council of America survey puts the figure at 17 percent.

The Disadvantages of a Lump Sum 401(k)

A small percentage of companies distribute 401(k) matches to their employees in one lump sum each year, rather than contributing to each paycheck throughout the year. This system can be detrimental to employees’ 401(k) balances if they miss some years’ matches when they change or lose jobs.

Standard 401(k)

401(k) balance

ASSUMPTIONS

Employer match received

regularly every two weeks

throughout each year

$600

,000

A worker with a starting salary of $40,000 contributes 10 percent of it to a retirement account. The employer matches 50 percent of the employee contribution, up to 6 percent of salary. After inflation, investments in the account earn 4 percent each year, and the annual salary increase is 1 percent. The worker changes jobs seven times in 40 years.

$500

$595,272

FINAL BALANCE

$400

$300

$200

Lump sum 401(k)

Employer match missed

in seven of the forty years

because of job changes

$100

$547,611

FINAL BALANCE

0

0

5

10

15

20

25

30

35

40

YEAR

Source: Vanguard

Last-day rules tend to be a bit more popular among banks. There, however, it may not hurt employees quite as much, since employees tend not to walk out under their own power until after they’ve gotten their year-end bonus. If they hang around long enough to cash that check, their match will have already cleared. (Midyear retirees usually get their matches as well.)

IBM generated a fair bit of attention in late 2012 when it adopted a last-day rule, and a couple of United States senators tried to pressure it into reversing its move. It refused, and it was hard to make IBM the boogeyman given that its 401(k) match is extremely generous compared with most other companies. It also offers free comprehensive financial planning to employees, something more employers ought to offer.

Those last-day-rule survey numbers haven’t grown much over time, not yet anyway. But there is reason for concern. The IBM move drew enough notice that a move to year-end 401(k) contributions is now on the menu of cost-saving changes that many employers consider each year. How much they could save depends on annual staff turnover, among other things.

As more employers automatically enroll employees in the 401(k) plans, those employers are naturally paying more in matches. Sometimes it doesn’t cost that much more, say if over 90 percent of employees are already participating. But Rob Austin, the director of retirement research at Aon Hewitt, says that in rare cases the cost increase could approach 25 percent.

That money has to come from somewhere, and some employers may be willing to bet that workers won’t understand the impact of a move to a last-day rule. But if every employer made a similar move, the numbers would grow quite large. Vanguard ran two calculations for me over a 40-year period, assuming the employee worked from age 25 to 65. The starting salary was $40,000, with 10 percent of it going to the retirement account, plus an employer match. The match was 50 percent of the employee contribution up to 6 percent of salary, a formula many employers use. The worker changed jobs seven times in 40 years, an assumption based on figures that the Bureau of Labor Statistics has generated.

Photo

Credit
Robert Neubecker

Vanguard took inflation into account and used today’s dollars in its 4 percent real investment return assumption and 1 percent annual wage raise projection. The result was an ending retirement account balance of $595,272 for an employee who received an employer match all 40 years and got it every two weeks. The person who didn’t get the match in each of the seven years when there was a job change, however, ended up with $547,611. That’s a difference of $47,661. (In the 33 other years, the person received the match at the end of the year.) Without any inflation adjustments in the original numbers, which is how it might look if you were using a standard web-based retirement calculator to make a basic projection, the difference would be $190,845. Some employees might get lucky and have their match arrive at the end of a year like 2008, when American stock markets suffered enormous losses. Others might end up leaving employers in years like 2013, when it would have been awfully nice to have every extra cent possible riding the markets upward.

Certain people may look at all this and figure a last-day rule is better than employers reducing a match, say to 4 percent from 5 percent. But employers are unlikely to make a permanent move like that. Not only does it affect everyone in an obvious way, amounting to a wage cut, it also has the potential to throw the plan out of balance. Bigger matches provide an incentive for more low-paid workers to contribute. If they don’t participate in enough numbers, it can place the plan in violation of federal rules. And without a 401(k) plan, there won’t be any more pretax contributions that are especially valuable to the highly paid executives who make the call on whether to cut retirement plans in the first place.

It’s entirely possible that a more generous retirement plan can lead to lower week-to-week take-home pay. After all, if it’s an either-or proposition, employers may favor a generous 401(k) program and offer raises of, say, 1 percent instead of 2 percent. But many employees spend raises rather than saving them. The upside of a good employer matching contribution is that it lands in an account that comes with significant penalties for people who try to take the money out early. For those who resist temptation, the savings multiply over time.

So there are a couple of lessons here. First, small changes can make a big difference over time. If you want more evidence of that, check out our online calculator that shows what can happen if you change your savings rate by just one percentage point.

The 1% More Savings Calculator

Increasing your savings by one more percentage point – or even better, another percentage point a year – can add up to big additional savings over time.

In order to view this feature, you must download the latest version of flash player here.

Savings are shown in today’s dollars, assuming inflation is 3 percent per year.

FEB. 14, 2014

The New York Times

Second, the change at AOL might well have simply sailed through had Mr. Armstrong not tried to pin it partly on a couple of infants. He may have done us all a favor, though. In an Aon Hewitt survey of employers taken right after IBM announced its change, 22 percent of them said that the primary barrier to moving to a last-day rule was concern about their own employees reacting badly.

Now AOL has inspired us to learn the full scope of the potential cost if last-day rules were to truly catch on, and employers will know that we know. Hopefully that concerns them even more. In the switch from pension plans to 401(k) and other programs where employees bear all of the risk, we’ve already lost plenty. So this seems like one of many good places to draw a line in the sand and demand no further cutbacks. Keep it in mind, because some other employer will undoubtedly try something like this again, sooner rather than later.

A version of this article appears in print on February 15, 2014, on Page B1 of the New York edition with the headline: Beware the End-of-Year 401(k) Match. Order Reprints|Today's Paper|Subscribe